How Does Loan Modification Affect Your Credit?

One of the great concerns shared by many homeowners who have missed several mortgage payments is what options are available to them, and how each option can affect their credit rating. While these borrowers know that their credit has deteriorated severely due to the foreclosure situation, they also want to preserve as much as possible their chances of borrowing money in the future.

Loan modification is the latest trendy method to stop foreclosure, with numerous government programs subsidizing lenders and homeowners. Thousands of foreclosure consulting firms offering to help borrowers negotiate with the banks (for a fee) have also cropped up all across the country.

While modifying the terms of a mortgage can be a great plan for some borrowers, few people have really questioned how a modification will be reported to the credit agencies. They are somewhat similar to refinancing a home, entering into a forbearance agreement with a lender, and even filing a Chapter 13 bankruptcy.

Government rules, until very recently, have also been unclear as to how lenders should report a loan modification on clients' credit histories. Some banks would have the record state "paid as agreed," while others would designate the payments as "partial payments." Some would even just keep the loan in a state of "foreclosure" until the temporary modification or repayment plan was completed.

All of these different approaches had widely varying effects on a borrower's credit score. Having a loan shown as "paid as agreed" was obviously the best solution. Partial payments is considered a negative to prospective lenders and would cause a decrease in the credit score. Having a credit report show a foreclosure would be almost as bad as just having filed bankruptcy and discharged all of the debt.

To address all of these different approaches the lenders were using, the government implemented another new regulation to impose a consistent reporting requirement on the industry. This new rule applies to all government-subsidized mortgage modification plans, and it went into effect on November 1, 2009.

The new rule requires that banks report a mortgage modification to the credit rating agencies as "loan modified under a federal government plan." Another requirement is that this designation will have no effect on the borrower's credit (FICO) score. This is partly due to the relatively small number of people who have received a modification to avoid foreclosure.

Once there are more mortgages with the federal government designation, then the credit rating agencies will be able to decide how to change the debtors' scores. This will require more modifications to go through and past ones not to redefault back to foreclosure status.